China's Stimulus: The Big, The Bad and The Ugly?

As the world economy suffers through its worst crisis in over
70 years, the various G-20 participants have independently
implemented ways to rekindle global demand, and attempt to offset
what's now being termed as the "great recession" by leading
economists. In the U.S., Western Europe and Japan the emphasis has
been on a combination of aggressive monetary policies (taking
interest rates to near-zero levels and quantitative easing) and
fiscal initiatives, ranging from cleansing the international
banking sector's toxic loan/investment portfolios to
government-sponsored infrastructure projects and tax-related
incentives - all with the ultimate goal of breathing life back into
the terminally ill global consumer. China's approach to stimulating
its economy up to now has been all of the above and more, but its
central concern about how it contributes to correcting this global
problem is summed up from a famous Chinese proverb, "ONLY when all
contribute their firewood can they build up a strong fire."

When it comes to monetary policy, China's traditional method is
the tried-and-true tool of cutting interest rates, but since the
start of last year the People's Bank of China (PBoC) has cut rates
by only half as much as the U.S. Fed. While recent consumer prices
have shown a decline of 1.6 percent, giving some economists reason
for deflationary concern, bank lending has grown by 24 percent over
the past year. The true gauge of monetary easing is not the cut in
interest rates themselves, but whether those cuts actually succeed
in creating new loan demand, currently a big problem in the U.S.
China is one of the few countries in the world where credit has
accelerated since the global credit crunch, with the caveat that a
large portion of that new lending is via state-directed banks. On
the FX side of things, up until the crisis began last summer the
PBoC had allowed the yuan to rise by nearly 18 percent in
trade-weighted terms, but since last July the currency appreciation
has stalled in a tight trading band over concern for local
exporters.

In China, the correct measure of their fiscal stimulus is
dramatically understated by the true economic effect in the form of
public infrastructure investment via state-owned firms/local
governments, and financed through state-sponsored banks. It's been
estimated that new infrastructure investment, related tax cuts,
various consumer subsidies and increased spending on healthcare
will amount to a stimulus package by the central government of
about 3 percent of GDP in 2009 (with the actual money spent, 4
trillion yuan or $586 billion). If bank-financed infrastructure
spending is added into the overall number, the total is close to 4
percent of GDP. Chinese investment in railways, roads and power
grids was already booming before the crisis, but in the first two
months of 2009 total fixed investment was 30 percent higher in real
terms than in 2008, as investment in railroads had already tripled.
China's traditional method of stimulus has been on investment,
rather than consumption, but in its view this is the quickest way
to boost domestic demand.

As in the U.S., the Chinese government is aiming for a rebound in
home sales, since property ownership is a key way to spur private
consumption. Higher home sales encourage more domestic spending on
furniture and consumer appliances. Construction creates jobs and,
in fact, almost employs as many workers as the export sector. Since
last October, the government has encouraged people to buy houses by
cutting the minimum mortgage down payment on their primary
residence to 20 percent and reducing stamp duty and other taxes on
property transactions. Stronger sales are now feeding through into
new home building as reflected in June's 12 percent rise, the first
growth in 12 months.

In the year ending in June, fixed investment in China had surged
by 35 percent, car sales by 48 percent and home purchases by 80
percent. After falling dramatically last year, home prices are now
rising briskly again in some big cities and local share (equities)
prices have soared by nearly 80 percent from last November's lows.
While domestic spending has been spurred by the government's
aggressive stimulus, the catalyst of this dramatic turnaround has
been the scrapping of bank lending restrictions late last year. As
of June, new lending was more than four times larger than in 2008.
The big boost to domestic spending and the corresponding flood of
liquidity has raised concerns of elevated inflation, fueling a new
stock market and housing bubble and adding to a growing roster of
bad loans. According to one estimate, 20 percent of new lending
went into the stock market in the first five months of 2009. The
current pace of bank lending is unsustainable, but as America's
recent experience suggests, it's better to prevent bubbles forming
in their early stages than to mop up the mess afterwards. Recently
several high-level officials of the PBoC have voiced their concern
that lending should be curbed. Prime Minister Wen Jiabao has
recently signaled that he wants monetary policy kept fairly loose,
as exports remain weak and the government fears premature
tightening could derail the recovery. He is also keen to continue
creating jobs and maintain social stability in the months before
the 60 th anniversary of Communist party rule in
October. In the end, the PBoC has begun to tug gently at the reins,
has nudged up money market interest rates and has warned banks that
it intends to increase its scrutiny of new bank loans.

Another reason for the dramatic economic rebound this year is that
much of the slowdown was self-inflicted, rather than the result of
America's economic collapse. In 2007, concerns about the economy
overheating prompted the PBoC to curb the flow of credit for
construction and home buying, causing China's economy to slow
sharply even before the global financial crisis began last summer;
however, after last fall's big drop, the financial credit tap was
turned back on full. Despite the recent lending boom, Chinese
banks' mortgage lending is still very conservative compared to
lending in the U.S. as illustrated at the peak of America's housing
bubble when it was relatively easy to get 100 percent financing for
a home.

The underlying debate continues to be whether China's stimulus
programs have been big enough or if the loose credit to finance the
stimulus programs will create non-performing loan problems down the
road. Exports fell by a sharper-than-expected 26 percent in Q1'09,
and continues to be weak. The 12-month growth rate in industrial
production has dropped to only 3.8 percent in Q1, with retail sales
dropping by nearly 15 percent for the same period. On the positive
side, China's year-on-year (YOY) growth rate is approaching 8.0
percent in Q2'09, but the more astonishing comparison of the
headline number was the change from Q1'09 to Q2'09, which by some
estimates has shown an increase of 16.5 percent on an annualized
basis. China's economic stimulus has clearly been hugely effective
up to this point, but many worry it may be working too well.

China's various stimulus programs have up to now dragged growth
back up the 8 percent level, but they cannot keep the economy
running at this pace if global demand remains depressed. The need
for China to shift the mix of growth from exports to consumption
has become even more urgent during this crisis. Chinese officials
are probably right in saying it will take years of high levels of
public spending on healthcare and a social safety net to put a dent
in household savings. However, the lesson learned from America's
financial crisis for China seem to be in plain sight: overly loose
credit should never be ignored otherwise China's fire could burn
out down the road.

As the world economy suffers through its worst crisis in over70 years, the various G-20 participants have independentlyimplemented ways to rekindle global demand, and attempt to offsetwhat's now being termed as the "great recession" by leadingeconomists. In the U.S., Western Europe and Japan the emphasis hasbeen on a combination of aggressive monetary policies (takinginterest rates to near-zero levels and quantitative easing) andfiscal initiatives, ranging from cleansing the internationalbanking sector's toxic loan/investment portfolios togovernment-sponsored infrastructure projects and tax-relatedincentives - all with the ultimate goal of breathing life back intothe terminally ill global consumer. China's approach to stimulatingits economy up to now has been all of the above and more, but itscentral concern about how it contributes to correcting this globalproblem is summed up from a famous Chinese proverb, "ONLY when allcontribute their firewood can they build up a strong fire."

When it comes to monetary policy, China's traditional method isthe tried-and-true tool of cutting interest rates, but since thestart of last year the People's Bank of China (PBoC) has cut ratesby...Read More